The Relationship Between Rising Rates And Rising Ringgit

The Relationship Between Rising Rates And Rising Ringgit

 

Topic …

Generally, currency prices reflect the supply and demand for currencies. Two primary factors affecting supply and demand are interest rates and the overall strength of the economy.  

 

Country Of Case Study: Malaysia

While the Malaysian economy is seen to be fairly stable, the main question on investors’ minds is this – the direction of interest rates. 

 

If a country raises its interest rates, the currency of that country will strengthen in relation to other countries, as investors shift assets to that country to gain a higher return. Raising interest rates isn’t a bad thing. It is an indicator of a stronger economy which can now (2006) take on higher interest rates.

 

Factors to Support Rising Rates …

  • It is common knowledge that Malaysia is very much behind the curve when it comes to raising interest rates. Malaysia raised its overnight policy rate (OPR) for the first time in 8 years by 30 basis points to 3% last November (2005). 
  • There’s also the issue of inflation to further support an interest rate hike. The consumer price index has crept up to one of its highest level to 3.5% as at December 2005. Higher interest rates could be a buffer against the ravages of inflation.  (In fact, December’s 2005 inflation at 3.5% means that real interest rates in Malaysia are still negative and monetary conditions are still highly accommodative).
  • Others opine that a stronger ringgit could also improve foreign perception on Malaysia.  

 

The Impacts Of Higher Interest Rates …

  • Raising interest rates is a tough call. Can businesses take on a higher interest rates? If the cost of borrowing increases, will sufficient investments still be made? On the private consumption side, would it burden consumers? (Generally, economists are of the opinion that the Malaysian economy could do better with a stronger currency). 
  • Raising interest rates could help build sentiment on the ringgit. 

 

The Pros And Cons Of Stronger Ringgit …

  • In the Asian region, most countries try hard to suppress their currencies for export purposes. In the case of Malaysia however, a stronger currency doesn’t necessarily harm exporters. 
  • Certainly, it will promote domestic demand by encouraging consumption.
  • While exporters will be affected, lets not forget that a stronger currency also makes imported goods cheaper. A stronger currency will not affect exports severely. For example, prices of raw materials will fall, and this benefits the exporter. On a net basis, the effect is positive.  
  • It is negative in the sense that it may affect an export driven country like Malaysia, by eroding the competitiveness of exporters. Nonetheless, should the ringgit be allowed to strengthen gradually, the economy will have time to adjust, and this could be less disruptive. 

 

Effects Of Not Raising Interest Rates … Despite Rates Differential

  • Should Bank Negara not raise interest rates, this would further widen the differentials between the Malaysian and US rates. 
  • In the US earlier this month (2006), former Fed Chairman, Alan Greenspan closed his term by raising the federal funds rate for the 14th consecutive time, to 4.5%. If the OPR remains unchanged versus the rising US interest rate, this could lessen Malaysia’s gain versus the US dollar to date and dilute the desired effect of reducing imported inflation (Bank Negara does not target the exchange rate but the OPR as its policy instrument. Thus interest rates have an important role to play in determining currency movements).